The Saudi castle built on sand - and oil

The Saudi castle built on sand - and oil
Analysis: The long-term decline in oil prices poses a significant challenge to Saudi Arabia. The kingdom’s massive financial reserves mean it can delay facing this challenge, but not forever.
6 min read
19 August, 2015
Saudi Arabia controls 18 percent of the world's proven oil reserves [Getty]

The prospect of ongoing low oil prices means Saudi Arabia will have to diversify its economy and cut spending to reduce its massive budget deficit - currently $140 billion or 20 percent of its GDP - the International Monetary Fund (IMF) has said.

However, the economic belt-tightening and other reforms that may be imposed by the long-term decline in oil prices may pose a threat to the grand political bargain on which the Saudi kingdom is based.

The kingdom's massive foreign reserves have so far buffered the shock of falling oil prices. However, at current spending levels, Saudi Arabia's foreign reserves are declining by about $12 billion a month, according to the International Business Times.

The kingdom's reserves now stand at $672 billion, down from $737 billion a year ago. At the current rate, its reserves will exhausted in less than five years.

Maintaining production while pushing down prices was Riyadh's bid to drive rival producers not incorporated to the Organisation of Petroleum Exporting Countries cartel - such as the growing US shale industry - out of business.

It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought.
- Saudi Arabian Monetary Agency

The gamble has backfired spectacularly.

"It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought," the kingdom's central bank, the Saudi Arabian Monetary Agency, recently admitted.

Saudi Arabia's thinly veiled attempt to bankrupt non-OPEC oil producers and prevent them pumping up oil production - which would bring oil prices down yet further - has apparently fuelled the long-term price decline the kingdom hoped to pre-empt.

An oil giant with feet of clay

Controlling 18 percent of the world's proven petroleum reserves, and currently pumping 10.6 million barrels of oil a day, the kingdom's economy is massively dependent on oil. It is the world's largest oil exporter; oil and gas account for about 50 percent of its GDP and 85 percent of its export earnings, according to OPEC.

This is why the recent approximately 60 percent decline in oil prices, with the benchmark price of Brent crude falling from $107 a barrel in June 2014 to $42 a barrel now, has hit the kingdom so hard.

Further, the international oil market's outlook for the medium term is poor.

The slowdown in the Chinese economy will depress global commodities prices for the foreseeable future, and the Iran nuclear deal means sanctions on Iranian oil will be lifted soon, flooding into a market which analysts estimate is already running a surplus of of between one and three million barrels a day.

Iran has said it can increase its oil production by half a million barrels a day within a week of sanctions ending, and a million barrels within a month.

The ongoing military campaign in Yemen, which appears to have no end in sight, is another significant and open-ended burden on the Saudi budget.

More: Salman fishing in the Yemen - read Bill Law's analysis here

IMF recommends structural reform

While the IMF noted the effect of falling oil prices on Saudi Arabia's economy had so far been minimal because it had been running down its huge financial reserves, it said the kingdom had to cut expenditure to reduce its fiscal deficit over the next few years.

The fund, reporting on its routine Article IV consultation on the Saudi economy, also recommended the government begin to start taking on debt to finance its deficit and avoid exhausting its reserves.

The kingdom has so far only issued a $4 billion bond issue in July this year, but International Business Times reported it was also planning a $27 billion bond issue later this year.

The IMF recommended further development and liberalisation of its financial sector and its stock exchange, the Tadawol, which would help the government raise funds domestically without recourse to the international capital markets. The stock market opened to a limited number of foreign investors for the first time in June this year.

The fund also strongly recommended Saudi Arabia diversify its economy to lessen its dependence on its massive petrochemical sector, focusing on non-oil services and products that can be exported.

Finally, it strongly recommended the kingdom increase employment of Saudi nationals in the private sector. Many Saudis hold lucrative and secure jobs in the kingdom's large public sector.

During the Arab Spring, the kingdom spent more than $130 billion buying off dissent and beefing up its security sector with 60,000 new jobs.

The kingdom has made efforts to reform its labour market over recent years and encourage more Saudi citizens into the workplace - notably women, who are significantly under-represented in the workforce.

The employment rate among Saudi women has surged by 48 percent over the past five years, more than double the rate of increase among men.

However, this improvement in employment rates among both men and women is starting from a very low base. In 2014, the kingdom's employment rate among its working-age population was still a paltry 35.7 percent, while the private sector is still dominated by the kingdom's approximately ten million foreign workers.

The political problem of economic reform

The problem with the reforms the IMF has proposed is that cutting state expenditure and forcing Saudis out of their public-sector sinecures into the private sector might undermine the kingdom's grand political bargain.

One of the reasons Saudi Arabians have tolerated the al-Saud family's autocratic rule and their lavish lifestyles is because the kingdom has satisfied their material needs and provided them with comfortable lives.

The kingdom has recently conceded a limited political liberalisation, permitting municipal elections in 2005 and 2011. The municipal elections due this month will be the first in which women will be able to participate.

However, the high ground of the state - the central government, the army and security services - remain, for the most part, the effective preserve of the ruling family.

Like many other Middle Eastern states, Saudi Arabia has relied on a combination of repression and buying off dissent to maintain the status quo. But Saudi Arabia's wealth has meant it can buy off opposition more lavishly than most.

In 2011, during the Arab Spring, the kingdom spent more than $130 billion beefing up its security sector with 60,000 new jobs. And after his inauguration in January this year, King Salman bin Abdulaziz al-Saud distributed $32 billion in bonuses to public sector employees.

The al-Saud family has used its wealth on a massive scale to prop up its autocratic rule. The curtailing of the political largesse the family has used to consolidate its position may well undermine its rule.

While Saudi Arabia's massive financial reserves buy the kingdom breathing space, oil prices that remain stubbornly low for an extended period of time pose a potentially serious threat to its political order.

As the kingdom burns through its foreign reserves to maintain current levels of spending and fund an expensive military campaign in Yemen, it is also running down its political capital.